BP Prudhoe Bay Royalty Trust: This Trust Is Worth 50% Of Today's Price

| About: BP Prudhoe (BPT)
This article is now exclusive for PRO subscribers.

Ben Bernanke is trying his hardest to force investors into the stock market and riskier assets. Bernanke has forced interest rates down to near zero. Short-term CD's offer an investor practically zero interest, while 10 year Treasuries yield a "laughable" 1.50%. Retail investors are looking for dividends in the stock market to provide some yield, and they are taking quite a bit of risk that is not visible to most. BP Prudhoe Bay Royalty Trust (BPT) is currently trading over $60 higher than its Net Present Value or NPV. Retail investors are blindly buying this trust for its current 7.7% dividend yield. They are not worrying about the fact that there is only $83 in dividends left to be paid out, which is $54/unit NPV.

I realize as a trader that investors are trying to squeeze out as many dividends as possible before they drastically start to drop in 2018. Starting in 2024 there will likely be no more dividends to be paid, and the trust will dissolve. Over 90% of BPT is held by retail investors, and those investors as a whole have no idea what is going to happen to the dividends beyond 2018. The value of a stock/trust should trade as a function of its expected discounted cash flow. Currently, paying $115 for BPT, or even $75 in the future, is a losing proposition as NPV is only $54/unit. Any day investors could decide to value BPT at its proper value, and the stock could crater lower to $50/unit. In the meantime, investors are living on borrowed time.

BPT was formed on Feb. 28th, 1989, as a trust created by BP Alaska and Standard Oil, who both are wholly owned subsidiaries of BP PLC (BP). BPT receives 16.4246% of the first 90,000 barrels of daily production from the Prudhoe Bay Field. In the company's 10-K, the company says,

"BP Alaska anticipates that its average net production of oil and condensate allocated to the Trust from proved reserves will be below 90,000 barrels per day on an annual average basis most future years. The occurrence of major gas sales could accelerate the decline in net production, due to the consequent decline in reservoir pressure."

Furthermore, in the 10-K there is discussion based on average oil prices of $96 in 2011 about when royalty trust payments will end:

" … it is estimated that royalty payments to the Trust will continue through the year 2027. BP Alaska expects continued economic production from the Prudhoe Bay field at a declining rate after that year; however, for the economic conditions and production forecast as of December 31, 2011 the Per Barrel Royalty will be zero following the year 2027."

Now, let's look into the trust and see how it works.

Royalty Production

BPT receives 16.4246% of up to 90,000 barrels of daily production average for the quarter. The company can't receive any extra oil if production exceeds 90,000 barrels/day. So maximum barrels entitled to BPT would be 14,782.1 barrels per day.

Chargeable Costs

This is a fixed amount of costs that are charged by BP Alaska set forth at the beginning of the Trust in 1989.

(Click to enlarge)

Starting in 2018, the Chargeable Costs start rising at a more significant rate than between 2012-2017. This will be detrimental to dividends for BPT shareholders. After 2020, the Chargeable Costs increase at $2.75 per year.

Cost Adjustment Factor

The "Cost Adjustment Factor" for a quarter is the ratio of the Consumer Price Index published for the most recently past February, May, August or November to 121.1 (the Consumer Price Index for January 1989). The "Consumer Price Index" is the U.S. Consumer Price Index, all items and all urban consumers, U.S. city average (1982-84 equals 100).

As of 12/31/2011 the Cost Adjustment Factor was 1.742.

Example: The Adjusted Chargeable Costs for 2012 would be Chargeable Costs multiplied by the Cost Adjustment Factor. So $16.70/barrel x 1.76 = $29.39. (1.76 would be a 1% increase in CPI in 2012)

Production Tax

Current Alaska oil and gas production taxes are 25% basic tax rate, and a progressivity tax. "If the producer's average monthly production tax value per barrel is greater than $30 but not more than $92.50, the progressivity tax rate is 0.4% times the amount by which the average monthly production tax value exceeds $30 per barrel. If the producer's average monthly production tax value per barrel is greater than $92.50, the progressivity tax rate is the sum of 25% and the product of 0.1% multiplied by the difference between the average monthly production tax value per barrel and $92.50, except that the sum may not exceed 50%."

Example: If oil prices were $90 in 2012, Adjusted Chargeable Costs were 29.39. The tax would be on the $90 - 29.39 = 60.61. So the tax would be 25% flat tax, plus the progressivity tax rate of $60.61 - 30.00 = 30.61. 30.61 x .4% = 12.244%. So total tax would be 25% + 12.244% = 37.244% tax rate. And $60.61 x 37.244% = $22.57/barrel tax

Base Case Scenario:

  1. Oil production averages 84,000 bpd in 2012, declining at 1,000 per year till production stays static at 80,000 bpd.
  2. $90 average WTI price
  3. CPI of 2% annually which increases Cost Adj. Factor by 2% per year.
  4. Discount rate of 10%

(Click to enlarge)

With realistic assumptions of production, oil prices and CPI you can see the total dividends to be paid out is only $83.39. At an appropriate discount rate the true Net Present Value of these dividends is just $54.14. At more than $118/unit, BPT is trading at a massive premium to its true value. Investors should be very careful as the trust will likely stop paying dividends, and this could happen as soon as 2024. When the trust stops paying dividends, the price of BPT will almost likely be zero. I would suggest investors pack their bags and jump ship right now before the rest of the market comes to the realization of this trust.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Disclaimer: This article is intended for informational and entertainment use only and should not be construed as professional investment advice, but rather my opinions as a writer only. Always do your own complete due diligence before buying and selling any stock.